Fannie Mae and Freddie Mac could become key players in the subprime mortgage market as a number of private lenders flee the sector or tighten up their lending requirements.

The sector has experienced one calamity after another this year, with rising borrower delinquencies and a number of high-profile casualties, ranging from two Bear Stearns hedge funds and other subprime investors, including United Capital Asset Management's Horizon Funds, to private-sector subprime lenders such as the now-bankrupt New Century Financial Corp., which made $60 billion in subprime loans in 2006. A report by Credit Suisse analysts last week estimated that banks could lose as much as $52 billion due to collateralized debt obligations that invested in U.S. subprime mortgages. And last Wednesday, Moody's Investors Service lowered ratings on almost 400 2006-vintage MBS and threatened to downgrade more, while Standard & Poor's said it could downgrade $7.35 billion worth of subprime bonds.

Yet the wave of subprime misery could prove to be a tide of good fortune for the GSEs, which are reportedly already stepping up their purchases of subprime mortgages for their portfolios, while the drying up of private subprime mortgage lending is sending more borrowers into competing agency fixed-rate products. In some cases, the agencies are acting as the court of last resort for borrowers suddenly shut out of the private subprime market due to new, stricter lending requirements. "They are poised to pick up the slack," said one mortgage analyst who requested anonymity.

Freddie Mac and Fannie Mae currently own about $170 billion in triple-A subprime mortgage-backed securities, James Lockhart, director of the Office of Federal Housing Enterprise Oversight, reportedly said last month. At the end of last year, Freddie Mac, which earlier this year publicly committed to buying $20 billion in subprime mortgages that meet its product standards, had $124 billion of nonagency mortgage-related securities backed by subprime loans, of which more than 99.9% were triple-A. And according to Fannie Mae's most recent public figures, as of the end of the first quarter, about 2% of its single-family mortgage credit book of business was private-label MBS backed by subprime loans.

To be sure, Fannie and Freddie are not going to be delving too deep. As one mortgage bond investor said, "they're only going to skim the cream off the top." But even such a move could change the nature of subprime MBS, and, according to critics, could put the agencies on the line for greater delinquency-related risks.

Fannie and Freddie's new role as subprime mortgage mavens also makes political sense, as the agencies have spent the last few years under fire for everything from accounting practices to risk standards. So appearing as the savior of a floundering market is a notable way to improve their reputation among politicians, the analyst said. "The agencies would love to be seen as coming to the rescue of everyone's problems."

While Fannie Mae said it will not comment on its investment activities in the subprime space, Fannie Mae's CEO Daniel Mudd said in testimony before the House Committee on Financial Services this April: "We want subprime borrowers to have a fair shot at homeownership. We think simple, straightforward, fixed-payment mortgages generally are the best products for these borrowers. So Fannie Mae should not walk away and say the market turmoil is not our problem. We are concerned about a liquidity crunch in the subprime segment - the risk that as the turmoil shakes out, the flow of capital to finance subprime lending could slow to a trickle."

Mortgage market players said they've noticed the agencies pushing further into subprime territory over the past few months. Loan-to-value ratios "are rising and FICO scores are falling," said Art Frank, Deutsche Bank's director of MBS research, referring to recent Fannie and Freddie pools. "Each month we're seeing lower FICOs and higher LTVs than the previous month."

And as the agencies pick up more and more of the paper left on the table with the implosion of private sector subprime players, it's translating into a greater overall market presence. The GSEs' overall market share is on the rise, with Fannie Mae alone posting a 20% compounded growth rate in May on its total book of business, its book rising by 11% overall from January to May of this year.

Protected Enough?

The most pertinent question on many MBS players' minds is what the cut-off point will be for the agencies - how low will they go, and what potential risks are they taking?

"The agencies are sometimes doing loans down to 500 FICO scores - this is pure subprime territory," one mortgage analyst said, noting that 500 FICO is often considered the bare minimum score for most lenders. "If the agencies get more involved in the subprime sector, they're going to take more losses."

Naturally, a number of methods are in place for the GSEs to weed out the most troublesome borrowers. So a prospective borrower who had just posted a 90-day delinquency likely wouldn't find any takers at the agencies. Borrowers generally will need a year's clean payment record to qualify for a Fannie or Freddie mortgage, analysts said.

Could a further downturn in subprime borrower quality, such as a spike in delinquencies, be dangerous for the GSEs? Federal Financial Analytics, a Washington, D.C.-based watchdog firm, said that having to write down a substantial number of subprime assets could be painful. For example, looking at the GSEs' nontriple-A positions, a writedown of 15% to 30% could result in as much as a $3.6 billion hit for Fannie Mae, and a hit in the $1.5 billion to $3 billion range for Freddie Mac, the firm said in a recent report on the sector.

A Freddie Mac spokesman said that the agency's involvement in subprime has been through the purchase of triple-A MBS, not CDOs. "The value of the securities we hold is dramatically different from that of CDOs, a fact the market recognizes," he said.

Federal Financial also said questions remain about the GSEs' intentions in the private-label mortgage market, particularly in secondary trading. "We note that Fannie continues to emphasize to the Street that it views its portfolio in an opportunistic' way, using it aggressively to support profitability," the firm wrote. "Even if [both GSEs] are not trading much now, each may well plan to do so going forward."

Yet several mortgage analysts said that such doom-and-gloom scenarios don't seem that plausible. "The agencies' credit enhancement business is so profitable that what they charge versus the actual risk gives them enough slack to absorb any real potential issues," one analyst said, noting that the agencies' high guaranty fees help offset any additional risks.

The Freddie Mac spokesman said that, "the level of protection from subordination actually increases for a period of time following the original securitization." For example, the subordination level on a typical triple-A subprime floating-rate ABS purchased in early 2006 is around 30% today, so even if half the mortgages backing that deal defaulted, the security still would not likely take any principal losses. - Christopher O'Leary

(c) 2007 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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